Wednesday, November 20, 2013

Financing a Sustainable Water Plan for Texas

In a series of three guest blogs over the next several days,
Sharlene Leurig, Water Program Director
for CERES, examines the details of Proposition 6, the water
project financing measure approved
by Texas voters on November 5th.Proposition 6 amends the Texas constitution to appropriate $2 billion
from the state’s Rainy Day Fund to seed a new water infrastructure loan fund directed
to water supply projects included in the State Water Plan.

Sharlene’s three posts examine how this new fund will work
(in concert with House Bill 4, passed in the recent session of the Texas
legislature) and what it could achieve—or fail to achieve—in terms of Texas’
water security.Today’s post focuses on
the mechanics of the fund and what choices the Texas Water Development Board
(TWDB) is likely to face in ensuring that the $ 2 billion appropriation is used
for maximum public benefit.The second
post looks at how administration of the fund will be affected by the new
project prioritization process authorized by House
Bill 4, the companion legislation passed earlier this year.The third post explores whether and how the
fund can be used to support water conservation projects.

Installment 1: Proposition 6 and the Mechanics of

Funding State Water Plan Projects

This post examines how the new infrastructure loan fund will
operate and the choices that will need to be made to ensure that the funds are
allocated for maximum public benefit.It
explores the tensions between using the new fund for “state participation” in longer-term,
big-ticket projects, such as reservoirs and pipelines, versus distributing
funds more widely to smaller, near-term projects across the state.(Note:
the following discussion draws on an excellent analysis of the mechanics of Prop 6 and differences
with existing financing mechanisms by the Energy Center at the University of
Texas School of Law.)

The 2012 State Water
Plan estimates that the cumulative capital cost of all recommended water
management strategies through 2060 would be $53.1 billion, only $26 billion of
which the Regional Planning Groups reported could be financed through local
capacity.As part of the 2012 Plan,
TWDB recommended that the Legislature “develop a long-term, affordable, and
sustainable method to provide financing assistance for the implementation of
the state water plan.”

This recommendation was taken up by the Legislature in the
2013 session in three pieces of legislation: House Bill 4, House Bill 1025 and Senate
Joint Resolution 1. Collectively, these bills: restructured the Texas Water Development Board
(see TCPS’s post on the restructuring here), established
the State Water Implementation
Fund for Texas (SWIFT); and sent voters a ballot proposition to approve
the transfer of $2 billion from the Economic Stabilization Fund (“Rainy Day
Fund”) to SWIFT. With Proposition 6 approval, the $2 billion will be
permanently transferred from the State Treasury to a trust held by the state on
behalf of the Texas Water Development Board, to be used exclusively for the
financing of recommended water management strategies in the State Water
Plan.

TWDB is the state’s water infrastructure financing agency,
providing $14.3 billion in loans for water and wastewater infrastructure across
the state over the last 56 years. TWDB makes use of its superior credit rating
and low borrowing costs to raise money through bond sales. It then lends that
money to local sponsors of water projects at a lower interest rate than what would
be available to the local if it sold its own bonds in the open market. For very
small systems, the subsidized lending made available by the TWDB is especially
critical as they have fewer options for borrowing money.

Despite this substantial amount of financing activity at the
state level, Texas water infrastructure needs have been growing, while TWDB’s
lending capacity has been limited by Article III, § 49 of the state
Constitution, which generally prohibits the state from issuing debt without
voter-approved expansion of constitutional authority.

In 2011, Texas voters approved a constitutional amendment
granting TWDB authority to issue up to $6 billion worth of debt for the Texas
Water Development Fund II.One of the
issues in the Prop 6 election was the difference between the new Prop 6 funding
and the previously authorized $6 billion.The answer generally comes down to the state’s constitutional debt
limit.

While bonds sold under this new authority were considered
“self-sustaining” they are counted against the debt limit of the state—which
prohibits new bond issuances when the percentage of debt service payable by
general revenue in any fiscal year exceeds 5% of the average unrestricted
general revenue for the past three years. This can theoretically limit the
ability of the TWDB to issue future bonds. So while the TWDB technically could have $6
billion of active market debt, it is constrained in its own debt issuance by
the larger set of debt obligations undertaken by other Texas agencies and by
the state’s constitutional debt limit.

Thus, H.B. 4 and Prop 6 seek to create a self-sustaining
funding mechanism for water supply projects that can grow beyond the initial $2
billion allocation without bumping up against the state’s debt limit. That is,
the $2 billion can be used to fund much more than $2 billion in capital costs,
but the total amount of financing will depend on how the funds are used.

________________________________

Table 1 provides a definition of some terms that are key to
understanding the specifics of the new financing mechanisms.

A fund that is
structured so that repayments can be used to make more loans. As borrowers repay their
loans, this money is made available to new applicants. A fund has fully
revolved when all of the original principal lent has been repaid

Bond

A debt
investment in which an investor loans money to an entity (corporate or
governmental) that borrows the funds for a defined period of time at a fixed
interest rate. Bond buyers are repaid both principal and interest

General Obligation Bond

A municipal
bond backed by the credit and "taxing power" of the issuing
jurisdiction rather than the revenue from a given project. Also called a “GO”
bond. Most bonds issued by the Texas Water Development Board have been GO
bonds.

Revenue Bond

A municipal
bond supported by the revenue from a specific project, such as a wastewater
treatment plant or reservoir. Revenue bonds are municipal bonds that finance
income-producing projects and are secured by a specified revenue source. Most locally-financed
water infrastructure in the United States is financed by revenue bonds repaid
by payments from water or wastewater system customers.

Credit Enhancement

A method
whereby a borrower attempts to improve its debt or credit worthiness. Through
credit enhancement, bond buyers are provided with reassurance that the
borrower will honor the obligation. Credit enhancement can take many
different forms, including additional collateral, insurance, or a third party
guarantee to pay a defined amount of principal and interest. Credit enhancement
reduces credit/default risk of a debt, thereby increasing the overall credit
rating and lowering interest rates for the borrower.

Deferred principal/interest loans

Loans can be
structured using terms that allow the borrower to defer payments for a
specified period of time. Lending terms can defer principal payments,
interest payments or both. For example, a loan with a 10-year deferred
principal period would mean that for the first decade, the borrower would pay
only interest on the amount borrowed, and not begin paying down the principle
until after the 10-yr period.

Leverage

Leverage is a
technique for multiplying limited funding by using those funds as collateral
for debt issued. For many years, the Texas Water Development Board has used
leverage to amplify the amount of funding it receives from the Environmental
Protection Agency under the EPA’s State Revolving Funds for water and
wastewater projects. TWDB issues bonds secured by its State Revolving Fund
allocation. The proceeds of those bonds are then used to lend money to local
water project sponsors to comply with drinking water and surface water
standards. The money received from the EPA is invested by the TWDB in
low-risk securities, like Treasury bonds. That investment is pledged as collateral
to bond buyers, thereby securing a strong credit rating and low borrowing
cost for TWDB. In addition, the interest gained by its investments is used to
subsidize the interest rate for TWDB’s borrowers. Through leverage, TWDB is
able to make more money available to its borrowers

SWIFT AND SWIRFT

Prop 6 enables the TWDB to expand the amount of loans available
to local sponsors applying for financial support for water supply projects, by
creating two separate but related funds: 1) the State Implementation Fund for
Texas (SWIFT) and 2) the State Water Implementation Revenue Fund for Texas
(SWIRFT). Though the latter has received less media attention, it is actually
the more important of the two when it comes to the matter of growing the $2
billion seed fund.

SWIFT exists to subsidize loans made by the TWDB to local
sponsors of water supply projects—it is simply a dedicated pool of money to
allow TWDB to lower the effective interest rates paid by its borrowers. SWIFT
can only be used to subsidize lending through five of TWDB’s funding programs.Four of these programs are briefly described
in the table below; the fifth, SWIRFT, is described in Table 2.

Table 2.TWDB Water Financing Programs

Eligible

TWDB Program

Purpose of Program

Water Infrastructure Fund

Subsidized and deferred loans for state political
subdivisions and water supply corporations, for projects in SWP or approved
regional water plans

Rural Water Assistance
Fund

Loans for political subdivisions and nonprofit water
supply corporations, for infrastructure or for consolidation or
regionalization

Agricultural Water Conservation Fund

Loans for political subdivisions, colleges, interstate
compact commissions and nonprofit water supply corporations, for conservation
projects

State Participation Program accounts in Texas Water
Development Fund II

Deferred interest obligations to repurchase TWDB’s
temporary ownership interest in facilities, for political subdivisions and
water supply corporations

These four programs are funded by the TWDB through the sale
of general obligation bonds, which are then used to create revolving loan funds
(meaning that as borrowers repay their debts to the board, the fund is
replenished to be made available to other beneficiaries).

At its heart, SWIFT is a means of subsidizing these revolving
loan funds. There are four types of subsidy SWIFT can provide: 1) low-interest
loans (TWDB may lend at as little as 50% the rate of interest at which it
borrows); 2) longer repayment terms for loans; 3) incremental repurchase terms
for projects in which the state owns a share; and 4) deferral of loan payments.
For example, under Option 1, if TWDB can borrow money at 3%, SWIFT funds could
be used to lower the interest rates of the TWDB’s own lending programs to as
little as 1.5%. An example of Option 4 would be TWDB purchasing up to 80% of a
water supply facility, with no principal repayment due from the borrower for as
long as 20 years.

Because SWIFT subsidizes revolving funds (repayments from
existing borrowers are used to make new loans), SWIFT could enable more than $2
billion worth of projects over time as loans are repaid with interest.Combined with SWIRFT, however, SWIFT can, in
theory, be leveraged to provide substantially greater amounts of financing.

SWIRFT is one of the funds that may receive disbursements
from SWIFT.Like SWIFT, SWIRFT can only
be used to finance water projects in the State Water Plan, through same set of
existing TWDB loan programs to which SWIFT is targeted (those in the table
above). Unlike the other funds eligible for SWIFT subsidies, SWIRFT is
capitalized through new revenue bonding authority granted under H.B. 4, meaning
it is totally free of any constraints related to the state debt limit. Also, unlike the other four programs eligible
for SWIFT subsidies, SWIRFT revenue bonds can be used for an expanded set of
financial assistance tools, including direct loans to local water project
sponsors, purchasing of debt obligations from these local sponsors, or credit
enhancement for TWDB’s own funding programs.

SWIRFT thereby opens a new chapter in the board’s financing
programs. The credit enhancement component of SWIRFT is especially important to
understand because of its potential for amplifying TWDB’s lending capacity. Under H.B. 4, TWDB may pledge SWIRFT as
collateral for the debts it incurs through the funding programs eligible for
SWIFT support. In this way, SWIRFT could increase substantially the amount of
debt TWDB could sell, as bond buyers would be promised revenues from borrower
repayments and have as added security access to SWIRFT funds in the event that
borrower repayments fell short of TWDB’s own obligations.

This credit enhancement authority under SWIRFT, combined
with its revenue-backed bond authorization collectively create the potential
for TWDB to multiply the $2 billion authorized by voters to provide up to $26
billion in total financial support. That
is an important figure only in as much as it is the full amount of state
financial support requested by Regional Planning Groups in the 2012 State Water
Plan. (Whether the political subdivisions and water authorities who participate
in the Regional Planning Groups will ever ask the Board to make the full $26
billion available to them is another matter entirely, and will be discussed
more fully in the second blog in this series.)

However, there are a number of factors that will determine
how much the $2 billion appropriation to TWDB will actually grow over time.That will in turn determine how well the new
funds can be used to support the wide range of needs in the State Water Plan,
from conservation and reuse, to smaller scale projects in rural areas, to
larger, longer-term projects proposed for growing urban areas.

As one option, TWDB could simply move the $2 billion through
SWIFT, bypassing SWIRFT, and directly support its existing funding programs.
While the money would be repaid to SWIFT over time, it would not necessarily take
advantage of leverage to grow the $2 billion.It would then be simply be a $2 billion revolving loan fund,
recapitalized as borrowers repaid their debts to the board, with (subsidized)
interest. In addition, if SWIFT is managed to provide financing subsidies (cash
outflows) that outpace the value gained in the fund through market investments
(cash inflows), the $2 billion could be substantially drained.

Another option would be for TWDB to put the lion’s share of
the $2 billion into the State Participation Program fund.This fund is generally used for longer-term,
big-ticket projects, such as reservoirs and pipelines, a number of which are
proposed in the 2012 State Water Plan.The State Participation Program allows TWDB to purchase a temporary
ownership stake in a water project, with the idea that the loan would be paid
back after the project was built and operating near capacity.Nearly 30% of funds the state has already made available to projects in
the State Water Plan have been through programs with deferred repayment,
including some $93 million through the State Participation Program in which repayment
of the principal typically is deferred for 20 years, and $189 million through
the Water Infrastructure Fund Deferred program, which defers principal and
interest for up to 10 years.

This approach, however, would tie up most of the money in
deferred loans, as illustrated by a January 10, 2013 memo
to the Members of the State House of Representatives from H.B. 4’s sponsor,
House Natural Resources Chairman Allan Ritter:loans with 20-year deferred repayment periods would prevent SWIFT from
fully revolving for more than 30 years.

If most of the SWIFT seed funds were sent directly to the state
participation programs with deferred payments, then these few borrowers would
receive the greatest benefit, and the opportunity to use the Prop 6 funds to
shore up water security throughout the state could be compromised.In essence, a “big dog eats first” approach
to using the new funds would mean that smaller projects for meeting real
short-term water needs in smaller communities, including throughout rural
Texas, could be undermined. On the other
hand, a more balanced approach, more equitably distributed among different
financing options, would allow greater leverage for the $ 2 billion and cover
more water needs throughout the state.

The TWDB now has the task
of balancing these competing interests, all of which will take place in the
context of the project prioritization process set up by HB 4.We’ll look at that topic in our next blog.

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